The are some truths that are so obvious that we never question them. The virtues of value investing is one of them.
From 1927 through 2019, value stocks outperformed growth stocks 93 percent of the time over rolling 15-year time periods, according to the data compiled by professors Eugene Fama and Kenneth French. The value premium—the excess return over growth stocks—was 3 percent per annum.
Question: If value investing held a structural advantage over multiple market cycles, how does one explain its worst-ever performance compared to growth stocks in the last decade?
Fact: The Russell 1000 Growth Index skyrocketed 318 percent in the last ten years while the Russell 1000 Value Index is only up 115 percent. Growth stocks have outdone value by 25 percent year-to-date.
The rub: Should investors side with a truism that has stood the test of time or adapt to the changing landscape?
This seems easy to resolve, as we believe the reason for value’s persistent outperformance is widely misunderstood.
Get smart: Rather than cheap valuations, the biggest driver of value returns was sector composition.
Value outperformed growth for most decades since the 1930’s because of overweighting in energy, materials, and finance—the dominant industries of the past century.
Oil boomed, automobiles and planes took off, and the materials sector answered tireless demand for road systems, electricity grids, factory upgrades and the non-stop construction of warehouses, offices, and homes.
Flashback: From 1930 through 1980, energy and materials represented as much as 20 percent of the stock market—each. Oil tycoon J. Paul Getty became the world’s wealthiest man in the 1960s.
The financialization of the US economy from 1980 onwards boosted the financial sector, which had the largest weighting in the stock market by 2007. Warren Buffett was now the world’s richest man, earning a fortune investing in America’s biggest banks and insurance companies.
Over the past decade, these important sectors have faded from their former glory. Fallout from the global financial crisis and a commodity bear market put an end to value’s outperformance.
At the same time, technologies from smartphones to social media transformed our lives, giving rise to tech billionaires like Jeff Bezos, Mark Zuckerberg, and Elon Musk.
What this means: It doesn’t matter if value stocks are historically cheap versus growth stocks, as long as the global economy becomes more knowledge-based and reliant on new technologies, growth indices will outperform because of an overweight in the dominant industries of our time.
The Russell 1000 Growth Index has a 35 percent overweight in technology sector and a 13 percent underweight in financials against its value counterpart. That’s what’s driving growth outperformance more than anything.
The disconnect between markets and the economy will continue to grow.
Our thought bubble: The Second Industrial Revolution in the late nineteenth century was a great leap forward. At the peak of the railway bubble in 1880, the transport sector made up over 60 percent of stock market value.
What if the technology sector reaches those heights?
The world is not going back to the way it was. The idea of a new industrial revolution sparked by advanced AI models is capturing our imagination. If we include Alphabet, Amazon, Meta and Tesla, the tech sector is now 37 percent of the S&P 500.
Just imagine.
